By Patrick Allen, CNBC Senior News Editor
As Italian prime minister Silvio Berlusconi's government calls for a vote of confidence over his unpopular €25 billion ($31.45 billion) austerity package, Roger Bootle and his team over at Capital Economics are questioning whether the country holds great danger for the euro zone. "Perennially weak growth and a mountain of government debt mean that the Italian public finances are a potential time bomb waiting to explode," Bootle wrote in a research note. With much of the focus until now on the likes of Greece, Spain and Portugal, Bootle said Italy could soon be front and center on the sovereign debt story. "We think the size of the government's debts will eventually prompt the markets to turn their sights on Italy and a default is a distinct possibility," he wrote.
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"Since the 1970s, the government has consistently lived beyond its means and public debt has risen to around 115 percent of GDP - broadly in line with the Greek ratio. And since joining the euro, Italy has steadily lost competitiveness," Bootle wrote. "We think that it might take a decade or more of stagnant or falling wages to restore full competitiveness." The only chance of Italy getting its debt-to-GDP ratio below 100 percent would be for it to run a budget surplus of 5 percent over 15 years. "If doubts grow over whether the government is willing or able to do this, Italy could fall into a so-called 'debt trap.' Under this scenario, rising borrowing costs lead the debt-to-GDP ratio to increase at an accelerating rate, leaving the Government with no choice but to default."
"If the Government were to default on its debts and investors were forced to take a large haircut of say 50 percent, this would wipe out around 80 percent of Italian banks' tier one capital at a stroke, causing domestic financial market meltdown," he said. Bootle said foreign investors would face losses of around €400 billion. "Uncertainty about exactly which banks were worst affected would almost certainly lead to the seizing up of interbank lending markets and could prompt another deep global recession," he said. All the more reason for the EU and ECB to do all it can to prevent such an outcome.